While the bonds generally carry the interest rates of long-term investments, they give investors the benefits of short-term securities because their early call and redemption provisions make them less susceptible to interest rate fluctuations.

Market participants say investors can earn yields as much as 50 to 75 basis points higher on these securities than they can on money market funds and certificates of deposit. These higher yields can be obtained without substantially lengthening the maturity of the investments.

When interest rates drop, cushion bonds, or high-coupon, callable long-term bonds, begin trading on the basis of their expected call date rather than the stated maturity.

Cushion bonds generally trade above their initial call price, and because volatility is based on the call date rather than the maturity date, they tend to act like shorter-maturity bonds.

"Cushion bonds almost always work out to be a good investment," one municipal dealer said.

Such an investment is "something retail investors may want to consider," said Michael J. Ross, a first vice president in the tax-exempt fixed-income research department at Kemper Securities Inc. in Chicago. Ross lauded these bonds in the September issue of Kemper's Bond Briefs newsletter for municipal investors.

Ross said an institutional investor would probably want to sell cushion bonds because their price will not rise as much as a bond with a longer maturity or better call protection if rates continue to decline.

There are risks involved, however. If interest rates begin to rise, the securities may not be called. The bonds would then begin trading again like a long-term instrument.

Risks aside, an investor of cushion bonds would hope to collect several years of attractive coupon payments that would offset the premium price initially paid for the securities.

The bonds offer "above-average yield opportunities with only a modest amount of risk" in instances where the taxable equivalent yield to the call date is 150 basis points to 200 basis points higher than the yield available on U.S. Treasury securities with comparable short-term maturities, Ross said.

Cushion bonds are attractive for investors seeking investments with maturities of no longer than seven years, said Ross. He recommends purchasing cushion bonds with possible call dates beginning in the next two to five years.

"Retail investors generally have a much shorter-term horizon," of about three to seven years, Ross said. in that maturity range, he explained, more yield can be picked up without extending the maturity of the portfolio very far.

The Kemper analyst cited several securities that could make attractive cushion bonds. For example, on Sept. 29, the insured 6 7/8s of 2006 District of Columbia general obligation bonds offered a roughly 5% yield to the first call date, which is on June 11, 1996. The yield to maturity was 6.61%. The call price is 102 and the current price is 112.24, the analyst said.

The adjusted, or taxable equivalent yield, to the first call was 7.25%, or about 200 basis points above the yield available on the five-year Treasury.

"Anytime you can pick up additional yield without any additional risk, you're supposed to do that," Ross said.

But if interest rates rise substantially, the bonds will not be called and "the investor who didn't want a long-term instrument now has one," according to Michael Shamosh, municipal market strategist at Cowen & Co.

"If yields on the cushion bonds rise and drive the price on the bonds below the call price, the bonds begin to trade on a yield-to-maturity basis," he added.

Ross recommended that before purchasing the bonds, investors should determine whether they can accept the potential risk of extending the maturity of their portfolio if they are not called.

"Investors who cannot accept the extension risk should avoid cushion bonds," Ross wrote in the Kemper newsletter.

He said investors should also determine whether the bonds will be a good yield investment if they are not redeemed before maturity.

For an investor who can afford to lengthen the maturity of his portfolio, the risks of holding onto a cushion bond may be minimal, Ross said. This is because if interest rates begin to rise, initially the price of the callable cushion bond will change only modestly.

Lawrence C. Liebers, vice president of corporate/institutional services at Merrill Lynch & Co., said historically low tax-exempt yields have prompted record levels of refundings. As a result, supply has increased and the yields on pre-refunded bonds have risen.

Pre-refunded bonds now offer another attractive alternative for short-term municipal investors and cross-over buyers who normally purchase Treasuries or other taxable short-term securities, Liebers and other market strategists said.

One key advantage of pre-refunded bonds is that they are secured by an escrow fund of U.S. Treasuries. The escrowed bonds are sufficient to pay off the entire issue of refunded bonds at maturity. Since the bonds are secured by U.S. Treasuries, they carry gilt-edged triple-A ratings.

Shamosh of Cowen said that "for people who would normally buy Treasuries, purchasing pre-refunded bonds or escrowed bonds is the thing to do." Liebers said these securities make purchasing pre-refunded bonds "like buying tax-free Treasuries."

The bonds offer the same security as U.S. Treasury bonds, but bring in higher yields on an after-tax basis than the Treasuries.

Liebers pointed to a pre-refunded municipal bond maturing in five years as yielding in the 4.50% range, while comparable Treasuries yield about 5.15%. For an investor in a 31% tax bracket, the return on the Treasury after taxes are deducted is about 3.55%, Liebers calculated.

"Pre-re's make sense if they trade on top of comparable Treasuries," Ross agreed. But he said he believes cushion bonds offer investors even higher yields than those available oil pre-refunded bonds with similar maturities. Municipal dealers concur, but point out that cushion bonds also offer more risk because an investor cannot be certain the bonds will be called.

One risk with pre-refunded bonds, meanwhile, is the possibility that the investor could reinvest often sizable coupon payments in the exact lower-yielding securities he initially hoped to avoid, Shamosh cautioned.

For example, an investor who purchased $50,000 of pre-refunded bonds with a 9% coupon maturing in 1996 would receive approximately $2,250 each six months in coupon payments, Shamosh explained. "What do you do with it? It's a tremendous amount of cash that's being returned to you, but you can't buy another bond with that amount of money."

An investor would probably have to reinvest such coupon payments in shorter-term investments such as a money market fund, which would offer much lower yields than those available on the cushion bond. The overall return from purchasing the cushion bond would therefore be lower, Shamosh said.

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